By Karan Puri -- Defining a hedge fund is a difficult task considering the significant level of heterogeneity that exists within the industry both at an inter-strategy and at an intra-strategy level. But while regulators, investors and academics struggle to agree on the exact terminology, one thing is certain: assets under management continue to grow at a significant rate with institutional investors leading the way back in the game.

The primary reason? The Alpha chase.

Brief Background

The notion of ‘Alpha’ or excess returns over and above a particular benchmark is a vital part of any hedge fund marketing pitch today. Fund managers look to generate absolute returns irrelevant of market wide conditions by employing a variety of investment strategies and techniques. However, do these funds actually generate true alpha? Or an even more sensitive question would be ‘what is Alpha?’ and can it be differentiated from systematic exposure (Beta)?

Questions of the kind posted above are increasingly becoming common within academia and deserve detailed analysis before investment decisions are made by investors looking to allocate to hedge funds. So why is it important to consider this?

An Example: Short Selling

Unlike mutual funds, hedge funds can short sell freely and hence take advantage of falling markets and overvalued stocks due for correction. Modern portfolio theory reflects this ability in the parallel upward shift of the efficiency frontier. In other words, a long/short investment strategy becomes immune to market direction unlike a long only portfolio. This translates into a broader investment and portfolio diversification platform for hedge funds but not necessarily alpha generation! This is because if alpha was only creating a balanced portfolio, then investors could do so without hedge funds and especially their fees!

Another Example: Leverage

For starters, hedge funds are neither highly speculative vehicles nor do they attempt to mimic the risk taking of mutual funds. Most funds employ leverage that lies between the two extremes and its choice is usually a function of the underlying strategy structure. Hedge funds do not follow ‘buy and hold strategies’ and the employment of leverage essentially means greater portfolio risk which hides away in higher order moments of the return distribution of funds that typically reflect severe negative skewness and extreme positive kurtosis. Investors need to take into consideration the impact of these risks when considering risk adjusted returns that only take into account the standard deviation.

Two Trillion Dollar Industry – Another Explanation?

I do not intend to argue that hedge funds are a hoax! Indeed the industry has witnessed dramatic growth with funds reflecting exceptional performance particularly during volatile periods. I only suggest an alternative explanation that has played a major part in their success which is ‘Beta management’ or the systematic time varying management of market exposures that stems out of dynamic strategies.

The above graph represents the dynamic exposure of the CS Tremont Hedge Fund index to the S&P500 from 1994 to 2008 covering significant market events. Even at a diversified index level, the rolling systematic exposure clearly suggests the presence of dynamic beta management by hedge funds that avoided the stock market crash of 2000 but rode the bull market that followed.

A formal explanation of alpha is the part of the portfolio return not explained by the model. Rolling alpha values are consistently low with the exception of the 1997 to 1999 period which ties in nicely with the declining exposure to the S&P500 and hence the return being generated elsewhere not accounted for by the one factor model. Furthermore, a multi-factor model as proposed by Fama and French would mean a further downward pressure on alpha.

Alpha embedded in Beta?

The above arguments call for greater attention to be paid to the way hedge fund managers construct, monitor and manage their portfolios as a potential source of embedded alpha instead of coining it as an esoteric source of return. Doing so would lead investors to better understand their investment criteria, the inherent risks involved and may also provide greater negotiating power over contractual terms.

Conclusion

Since hedge fund investment is essentially a bet on managerial skill, the presence of this skill must be established and segregated from the mere flexibilities hedge fund enjoy! Even though hedge funds follow significantly different strategies to other fund managers, they are still very much part of the same financial markets and exposed albeit to varying degrees to the same market risks. Investors must understand the scope of their potential investments by analysing in greater detail the manager’s choice and use of investment techniques and consequently their impact on the historically generated returns. As one researcher has appropriately pointed out “If you can explain it away then don’t pay!”

Karan Puri is a PhD student in Finance at the University of Bath, Department of Accounting and Finance, U.K. He is currently in his second year as a doctoral student. His areas of expertise and research lie within the field of hedge funds. He undertakes both empirical and theoretical work on the performance of these funds. Contact Details: Email – kp212@bath.ac.uk; phone: (+44) 7823770026

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